Why Housing Has Stalled -- And Why Everything Else Will Follow

It's not easy being a mainstream economist. You spend your life building models
that become your professional identity. And when those models fail to describe
and predict reality, you're left wondering about the meaning of it all.

The latest case in point is US housing. Keynesian economic models say that
if you lower mortgage rates you get more houses bought, sold and built. A nice,
simple piece of cause and effect. But today's mortgage rates are at levels
that would have incited a buying frenzy a generation ago, employment is rising
-- and home sales, home building and mortgage originations are all flat-lining.

Both articles conclude that housing is weak and getting weaker. But the real
question is what this means for the rest of the economy. Is housing a discrete
sector dealing with its own supply/demand issues, or is it a sign of things
to come for consumer spending, government tax revenues, and business investment?

The argument for the latter scenario is based on the idea that newly-created
currency pouring into the financial system pumps up asset prices, which convinces
people that they're rich enough to indulge in new cars, new clothes and nice
vacations -- and more stocks, bonds and houses.

But this "wealth effect" only works when the amount of debt in the system
is low enough for new paper profits to change behavior. If people already carry
too much debt, then they don't feel comfortable borrowing even at historically
low interest rates, and inflated asset prices become harder and harder to support.
Either they stall or start moving lower, which shifts the wealth effect into
reverse and sucks the air out of the economy.

The reason that so many economists didn't see housing rolling over and don't
think it will affect the rest of the system in any event is that most Keynesian
models don't pay attention to society's balance sheet. A given amount of new
debt is supposed to increase "aggregate demand" by the same amount whether
the government and consumers are debt-free or buried under a mountain of obligations
taken on in years past. That's a false assumption of course. Liabilities matter,
and the fact that debt levels, especially student loans, are hitting records
probably explains why housing isn't behaving according to script.

The other fuel for a wealth effect-driven boom is the stock market. Here again,
a nice pop has coincided with a big jump in debt, in this case margin debt,
which investors incur when they borrow against stocks to buy more stocks. Late
last year margin debt hit a new record and since then has gone even higher.
Now it's at levels that, based on history, imply less bang for each new borrowed
dollar. Going forward it will be harder for investors to generate big returns
by borrowing money and buying more equities. Taking profits will begin to seem
more and more prudent, until sellers swamp buyers and the markets correct.

Click here for a great explanation of why pretty much every stock market valuation
measure is now flashing either yellow or red, from John
Hussman.

Assuming that equities plateau or start falling, what does that do mean for
government's strategy of using asset bubbles to pump up the consumer economy?
Probably it derails it. The question is when.

Hussman notes that periods of extreme overvaluation like today are good indicators
of low average stock market returns over the next decade, but not necessarily
great trading signals. Stocks might get more overvalued before they stop. But
that would raise the risk of a crash, which would have an even more serious
impact on investor psyches. So either way, this year or next, the wealth effect
will become the poverty effect, and asset owners will become asset sellers.

John Rubino is author of Clean Money: Picking Winners
in the Green Tech Boom (Wiley, December 2008), co-author, with GoldMoney's
James Turk, of The Collapse of the Dollar and How to Profit From It (Doubleday,
January 2008), and author of How to Profit from the Coming Real Estate
Bust (Rodale, 2003). After earning a Finance MBA from New York University,
he spent the 1980s on Wall Street, as a currency trader, equity analyst and
junk bond analyst. During the 1990s he was a featured columnist with TheStreet.com and
a frequent contributor to Individual Investor, Online Investor,
and Consumers Digest, among many other publications. He now writes
for CFA Magazine and edits DollarCollapse.com and GreenStockInvesting.com.